RDP 2023-05: The Impact of Interest Rates on Bank Profitability: A Retrospective Assessment Using New Cross-country Bank-level Data 1. Introduction

For much of the past decade, interest rates in many countries were at or near historically low levels. This raised questions about the consequences of low interest rates for bank profitability and implications for the transmission of monetary policy. While interest rates have risen more recently due to high inflation, this paper provides a retrospective assessment of the effect of low interest rates on bank profitability. The challenges and consequences of low rates may arise again at some point in the future, particularly given the neutral rate is estimated to have fallen significantly in advanced economies over the past few decades (Holston, Laubach and Williams 2017). This paper is unique in using proprietary bank-level data for 10 countries, with the effect of lower interest rates on bank profitability estimated by banking sector experts from each country.

This paper presents new insights on the direct impact of lower rates on bank profitability, after controlling for other factors that operate indirectly through monetary policy's independent impact on aggregate demand.^[1] All else equal, lower interest rates are likely to directly impact bank profitability by eroding banks' net interest margins (NIMs). This is because most bank assets earn a rate of interest that varies to some extent with the policy rate. However, some bank liabilities, including equity and transaction deposits, pay no or little interest and banks may choose not to reprice transaction deposits in line with the policy rate. As a result, lower interest rates are likely to lower NIMs. Moreover, the impact on margins could be larger in low-rate environments, when rates are at or near their effective lower bounds. This is because of the higher share of deposits at low rates that banks choose not to reprice lower in line with lending rates. The impact on margins could also be larger if rates have been ‘lower for longer’ as interest rate hedges become less effective over time.^[2]

While NIMs will tend to decline with interest rates, the overall direct impact on bank profitability is not obvious (CGFS 2018). Lower interest rates can decrease loan-loss provisions by reducing the cost of servicing debt and lowering default probabilities. Banks can also respond endogenously by increasing their non-interest income (for example, fee income) and reducing their costs of operating. Ultimately, teasing out the balance of these effects is an empirical question.

Quantifying the impact of lower rates on bank profitability and its components is relevant for policymakers. On the one hand, lower profits erode banks' ability to build capital buffers to absorb future losses. Lower capital can also weigh on lending (Gambacorta and Shin 2018), with reduced credit availability potentially weighing on economic activity. In a theoretical model, Brunnermeier and Koby (2018) propose a ‘reversal rate’ below which further reductions in the policy rate become contractionary under specific conditions.^[3] This is because of the negative effects of lower profitability on bank capital and the associated contractionary effects on bank lending. On the other hand, if banks choose to protect their profitability by not lowering interest rates on their lending after a fall in the policy rate then this could impair the transmission of monetary policy. Central banks have acknowledged these potential side effects and have in some cases adapted their operations in low-rate environments to lower the burden of low or negative interest rates on bank profitability.^[4]

Footnotes

While we are only concerned with estimating the direct impact of lower rates, it is important to recognise that lower interest rates indirectly contribute to higher bank profits by stimulating economic activity. [1]

Banks in some jurisdictions engage in interest rate swaps to hedge interest rate risk stemming from holding a greater amount of fixed-rate liabilities relative to fixed-rate assets. However, these hedges become less effective when rates have been lower for longer because they gradually roll onto lower interest rates. [2]

These include banks being subject to an occasionally binding equity constraint (and so being unable to raise external equity) as well as being net investors in debt securities. [3]

See, for example, Mario Draghi's quote from 27 March 2019: ‘We will continue monitoring how banks can maintain healthy earning conditions while net interest margins are compressed. And, if necessary, we need to reflect on possible measures that can preserve the favourable implications of negative rates for the economy, while mitigating the side effects, if any. That said, low bank profitability is not an inevitable consequence of negative rates.’ The proportionality assessment of non-conventional measures and the need to ‘counteract undesirable side effects’ is explicitly mentioned in the Strategy Review of the ECB, which was concluded in July 2021 – see the overview note (ECB 2021). [4]